Fear and Greed Blog

On Tuesday at 2:00 PM EST, the Federal Reserve will make its normal post-Open Market Committee meeting announcement.

Many commentators have speculated as to whether there will be a cut in the target Fed Funds rate and, if there is a cut, if it will be 25 or 50 basis points (even a 100 bp drop has been suggested).

Like others, I have given this matter much thought.

My conclusion: it really doesn't matter very much.

Sure, the equity markets may bounce if there is a 50 bp cut and fall if it is something less, but that is going to be a short-term effect (in my opinion anyway).

The problems that are facing the US and Global economies are not being driven by the cost of capital. The problem is risk aversion (or fear).

The sub-prime/mortgage mess is absolutely a problem. Monetary policy, however, will have little, if any, effect.

What Does Matter

I just read an interesting report issued in March by First American CoreLogic (you can get a copy of the report here by filling out an information form). The mortgage default problem will, according to the study, not have a significant effect on the overall economy and will play out over the next six years (although 2008 may be especially difficult).

While the economy can handle the direct effects of potential mortgage defaults, the the bursting of the housing bubble has created a problem (as well as an opportunity). In addition to creating a liquidity crunch for financial institutions, lending standards have tightened and interest rate spreads have increased. While the liquidity crunch may be temporary, it is likely that lending standards will be maintained; and there will be no more than a limited reduction in spreads.

There are, at present, $78.4 billion of high yield bonds and $272.3 billion of leveraged loans that are overhanging the leveraged market (according to Fitch Ratings).

Furthermore, between 2008 and 2010, $473 billion of leveraged loans and $104 billion in high yield bonds will mature and need to be repaid or refinanced (per this report from Fitch Ratings). This does not include debt that has yet to be downgraded!

Typically leveraged loans and high yield bonds are refinanced. In the current market climate, the ability to obtain new commitments is questionable.

It is likely (given higher spreads and tighter lending standards) that lenders would be willing to fund only a portion of the maturing debt, potentially leading to defaults or forced divestitures.

The Chinese have a saying: "from chaos comes opportunity." The challenge is to identify and exploit the opportunities created by the chaos. It will be hard for resource constrained investors to benefit from these opportunities. Institutional investors (particularly hedge funds and private equity funds), however, can profit greatly - if they can separate the wheat from the chaff (and come up with innovative structures).

Back to the Fed

In my opinion, the Fed should keep the Fed Funds target at 5.25% and cut the Discount Rate to the same level (a further 50 bp drop from the interim move).

I personally believe that there is significant risk of inflation, particularly if rates are cut. The continuing decline in the Dollar is inflationary, and the EU seems more likely to CUT rates than to raise them (leading the Dollar to decline even further and inflationary pressures to increase). This is merely opinion, however. Such decisions are made with incomplete and backward looking data. We can only deal with the consequences (positive or negative) after whichever action is taken.

If the Fed DOES cut the Fed Funds target, I hope they cut the Discount Rate to the same level. Borrowings at the Discount window have increased as banks have become concerned about the risks of lending to each other (either through Fed Funds or LIBOR). Furthermore, pressures from other fronts (the need to take more risky assets onto their balance sheets, increasing the required level of reserves - partly linked to the Structured Investment Vehicle/CDO mess) are adding to the liquidity crunch. LIBOR recently EXCEEDED 5.75%.

By the way:

The Core Logic report, while somewhat oversimplified, indicates that we should be more worried about a significant decline in housing prices than interest rates. It further indicates that lenders were overly aggressive in lending (17.6% of mortgages originated in 2006 are estimated to have no equity, 23.9% of the adjustable rate mortgages originated in that year have no equity).

I found the CoreLogic report while I was reading a report from the IMF that had the interesting title of Money for Nothing and Checks for Free: Recent Developments in the U.S. Subprime Mortgage Markets. The report is interesting, but I loved the title.